SEC Staff Reviewing Derivatives Trading by Funds

The Securities and Exchange Commission has said that its staff is reviewing whether there is a need to revamp derivatives trading rules for mutual funds and exchange traded funds.

The SEC said that it was the right time to have a look at the rules that govern derivatives trading by funds. It wants to determine if any changes are needed to provide better protection to investors. There has been increasing concern recently that derivatives trading has become too sophisticated to be governed by rules that were set many years ago.

The SEC acknowledged that regulation was not moving fast enough to keep pace with the changes in the derivatives market. It also said that particular attention would be given to how much risk funds are taking and how robust the overseeing mechanism of the fund managers is.

Derivatives are traded in a $600 trillion market worldwide and they are often blamed for the financial crisis. What was initially a brilliant idea to mitigate risks for companies and individuals, has rapidly evolved into a big casino for investment bankers and traders throughout the world. The sheer scale of the market is large enough to trigger a collapse of the global economy, and some glimpses of how bad the situation can be was seen when Lehman Brothers, a large Wall Street bank, collapsed in 2008.

Credit default swaps, an extremely risky form of derivatives, has come under most scrutiny. These instruments can be used to launch speculative action against even countries, creating problems on a massive scale. This was demonstrated recently when traders targeted Greece because of its fiscal vulnerability. According to the SEC, there is an urgent need to regulate such instruments so that both individual investors and the whole financial system can be protected.

The SEC said that it has already stopped approving new exchange traded funds (ETFs) that plan to allocate a large proportion of investments to derivatives. ETFs are special funds, which track a particular underlying asset or a whole index. As these funds usually trade in an automated manner, there is very little effort in overseeing the fund, which could increase the risk for investors when derivatives are involved.

Derivatives trading has also come under the scrutiny by lawmakers. The financial reform bill introduced by Senator Chris Dodd proposes to significantly change the rules of derivatives trading by banks, especially by making the banks more accountable.